What Is An Index Fund?

NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. No rational person would make investment decisions based on a blog post. Please consult with your financial advisor before taking any action.
A nice place to learn about investment terms is Investopedia. Here is there definition of an Index Fund.

A type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.

Good... but I'm not sure what they mean when they say, "... is said to provide...". An Index fund actually does these things. Unless, you get a very specific type of index fund that focuses on a small market segment. Let's look at an S&P 500 Index Fund.

Broad Market Exposure

This index fund invests in 500 stocks. 500 different US companies. This is very broad exposure. If one of those 500 stocks goes to $0.00 in just one day it will only bring down your portfolio 0.2%. The whole market can move more than that in a day. You will never even notice the loss. This also works on the upside, if one of those 500 stocks double it will only give you a 0.2% bump. This broad market exposure effectively reduces your volatility.

Low Operating Expenses

If you are in a 401(k) or a 403(b) you may see index funds with expense ratios as low as 0.5% to 0.8%. The average mutual fund has an expense ratio of around 1.6%. The extra 1% savings could make a big difference over time. If you go to Vanguard, you can get index funds with expense ratios lower than 0.2%.

Low Portfolio Turnover

If you are in a taxable account this can really pull down your performance. If a stock is held for more than a year than you will only pay capital gains of 15%. However, a stock sold in less than a year can be taxed as high as 35% - Ouch! An S&P index fund may change only 2-4 % of the funds in a given year. A managed fund can change 100% or more (sell twice) in one year. Even if your managed fund beats the market you may get killed on taxes.